To me, AI… not story, not graphics, not voice acting… AI is probably the most important thing in RPGs. That and character customizability (stats/skill-wise, not appearance).
I think difficulty levels should be about how smart/stupid the AI is, not about how many hit points enemies have and how much damage they do.
I don't think AI should be 'held back' too much. After all, human brain should hopefully still be better than the AI (unless the AI cheats that is). So what if there is a TPK? big deal, reload and try again. This is not PnP when a TPK means game over.